29 July 2008

Recent Readings on Financials

It seems safe to say that not all of America's financial-services companies will go out of business. In fact, over time, some might even recover a bit. So it's tempting to try to snap them up at the bottom.

Careful! Some of the smartest investors in the world have been trying to do this for the past 6-9 months, and almost al have gotten burned....For example (WSJ):

Private-equity specialist TPG bought into Washington Mutual at $8.75 a share in April. The stock price Monday at 4 p.m. was $3.95. Warburg Pincus bet on beleaguered bond-insurer MBIA in January at around $12, after an initial investment at $31 a share. Monday the stock was at $4.27. A bargain-hunting fund recently launched by Fortress Investment Group is down about 30%.

A bunch of brilliant folks including Hank Greenberg bought Lehman (LEH) at $28 two months ago. It closed around $15. The list goes on.

Blodget then notes from the WSJ piece that hedge funds are raising funds and preparing to pour money into the sector:

John Paulson's Paulson & Co. is the latest to cause a stir, with plans to launch a fund late this year to make equity investments in financial companies. When a bear like Mr. Paulson senses bargains, it could be a sign that the worst is over.

Other firms, like Morgan Creek Capital Management and Credit Suisse, have begun raising money that they will invest with hedge-fund traders looking for cheap financial assets. Private-equity firms specializing in financials, such as J.C. Flowers & Co., also are raising money to make purchases, according to investors.

In any case, the myriad woes of the credit system strongly suggests that the stirring stock market rally led by the financials in the wake of the Fannie-Freddie bailout and the crackdown on short-selling was mainly the product of short-covering.

Not exactly an original notion, but one well-supported by the data. Bespoke Investment Group points out that banks were the most heavily shorted group among the Standard & Poor's 1500 index in the latest short-interest numbers through July 15 -- the day the financials made their lows. Short interest hit 19.6% of an average bank stock's float; no doubt much of that has been bought back in the subsequent week. Last Thursday's wicked selloff suggested that's likely played out.

As the credit crisis prepares to mark its first anniversary, it's only fitting that the bulls claim the bottom has been reached. MacroMavens' Stephanie Pomboy notes similar declarations after bear-market bounces, as with the Nasdaq in 2001 and the Nikkei in 1990.

But, given the banking system's record exposure to real-estate assets, which continue to deflate, the fate of the financials -- and indeed the stock market -- seems tied to the housing market.

"As long as real-estate values continue to decline, banks will continue to frantically reduce their exposure," says Pomboy. " This is why it seems irrational in the extreme to anticipate a bottom in financials before the bottom in housing is in!"

Jason Zweig, also last Saturday but in the WSJ, invoked Graham & Dodd in questioning whether the financials are ripe for value investors, or are still solely in the realm of speculators:

You cannot even pretend to be protected against loss while real estate prices -- the wobbly foundation for most financial stocks -- are still crumbling.

Nor can you study the facts when it's unclear what the facts are. Each quarter, the banks set money aside in reserve against losses on their loan portfolios and say they believe those reserves should be adequate. The next quarter, they find out they were wrong. Loan-loss provisions at Washington Mutual, for example, have mushroomed from $967 million to $1.5 billion to $3.5 billion to $5.9 billion over the past four quarters.

The banks aren't lying; they're guessing. Whenever bankers talk themselves into believing that their assets are as liquid as stocks and bonds, they end up holding some stuff so rotten that you might not be able to unload it for a nickel at closing time in a fish market. That's why Graham warned decades ago that bank stocks are "a dangerous medium for widespread public dealings," prone to "absurd overvaluation" and "violent fluctuations." That's exactly the sort of warning people forget in financial boom times, as we had until last year – and in any bounce off the bottom, as we had earlier last week.

Financial CEOs could cast a vote of confidence in the future of their companies -- and give an immediate boost to the value of each share -- by buying back stock massively at these levels. Instead, share buybacks in the financial sector have fallen by two-thirds since the beginning of last year, to just $14 billion in the first quarter of 2008. Stuck in what Standard & Poor's analyst Howard Silverblatt calls "a state of shock and dismay," the heads of financial companies lack the cash or the confidence -- or both -- to buy in their own shares. If they can't or won't buy, why should you?

Don't get me wrong. I'm not saying there's no money to be made on financials in the next couple of years. But the potential for further losses is at least as great as the odds of big gains. When bankers themselves have no clue what their own assets are worth, there's no way most outsiders can determine which stocks are undervalued and which cannot be valued.

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